1. Accounting for Executives Week 6 15/4/2010 (Fri) Lecture 6

2. Part I Statement of Cash Flows

3. Learning Objectives 1.Understand the types of transactions that result in cash flows from operating, investing, and financing activities. 2.Develop an ability to analyze the statement of cash flows, including the relation among cash flows from operating, investing, and financing activities for businesses in various stages of their growth.

4. Overview of the Statement of Cash Flows The statement of cash flows … (a) explains the reasons for a change in cash. (b) classifies the reasons for the change as an operating, investing or financing activity.

5. The cash flow statement provides information about: ♦ cash receipts (cash inflows) ♦ uses of cash (cash outflows) ♦ during a period of time Inflows and outflows are reported for: ♦ operating ♦ investing ♦ financing activities The Cash Flow Statement

6. Define the Three Classifications of Cash Flows 1.Operations – cash flows related to selling goods and services; that is, the principle business of the firm. 2. Investing – cash flows related to the acquisition or sale of noncurrent assets. 3. Financing – long term and short term cash flows related to liabilities and owners’ equity; dividends are a financing cash outflow.

7. Cash Inflows and Outflows

8. Example of a Statement of Cash Flows

9. Components of the Statement of Cash Flows Cash received from sale of goods and services Cash received from sale of goods and services Cash paid for operating goods and services Cash paid for operating goods and services cash flow from operations cash flow from operations Operations -= Cash received from sales of investments and PP&E Cash received from sales of investments and PP&E Cash paid for ac- quisition of invest- ments and PP&E Cash paid for ac- quisition of invest- ments and PP&E cash flow from investing cash flow from investing Investing -= Cash received from issue of debt or capital stock Cash received from issue of debt or capital stock Cash paid for dividends and reacquisition of debt or capital stock Cash paid for dividends and reacquisition of debt or capital stock cash flow from financing cash flow from financing Financing -= Net change in cash for the period Net change in cash for the period = + -

10. Comparison of Cash Flow to Net Income ♦Net income is an accrual based concept and purports to show the long-term. ♦Cash flows purport to show the short term. ♦Consider the outlook for both short-term and long-term and consider that each is either good or poor. ♦A strong growing firm would show both good long-term and good short-term outlooks. ♦A failing firm would show both poor long-term and poor short term outlooks. ♦What about a firm with good cash flows (short- term) but poor net income (long-term)? ♦What about a firm with poor cash flows (short- term) but good net income (long-term)?

11. Chapter Summary ♦The statement of cash flows is presented. It reports the effects on cash flows of a firm’s operating, investing and financing activities. ♦Information in this statement helps in understanding: 1. How operations affect liquidity, 2. The level of capital expenditures needed to support growth, and 3. The major changes in financing.

12. Part II Using Financial Information to Manage Business Resources

13. Learning Objectives After working through this part, you should be able to: ♦Identify the main elements of the working capital cycle and describe the key factors to be considered when managing each part. ♦Prepare a cash budget and understand its uses in managing cash flow.

14. Working Capital ♦The working capital of a business is the difference between the short-term assets (current assets) and the short-term debt (creditors), amounts falling due within one year CURRENT ASSETS – CURRENT LIABILITIES Current Assets: Trade Debtors, Prepayments, Stock, Cash & Bank Current Liabilities: Trade Creditors, Bank O/D, accruals

15. Working Capital Cycle Below illustrates that a business can buy and sell its stock of finished goods for cash. However the majority of businesses buy and sell their stocks on credit terms and this creates the working capital cycle. Cash is used to pay suppliers for stock items or to pay trade creditors for stock bought on credit terms. The stock is sold either for cash or for credit. In the case of credit customers, there will be a delay before the cash is received from the sales. The receipt of this cash completes the cycle.

16. Operating cycle/ Cash conversion cycle A starting point to determine the level of working capital is to measure the length of time: ♦ between the purchase of stocks and the receipt of cash from debtors for the sale of the stock; and ♦the interval between when the cash is paid out for stocks and the cash is received in from debtors. Example A business buys and sells computers. It buys a computer for cash at a cost of £500. The computer is likely to be held for 15 days before it is sold. The computer will be sold on credit for £800. The debtors normally take 50 days to settle their debts.

17. Operating cycle/ Cash conversion cycle This illustrates that the £500 to purchase the computer is tied up for 65 days. This is the length of time the cash invested in the stock takes to be converted into cash being received from debtors. 1/3/05 Purchases 15/3 Sales 4/5 Cash rec’d from customer 65 days

18. Operating cycle/ Cash conversion cycle ♦Consider what will happen if the business purchases the computer on credit and pays its suppliers in 33 days. The impact on the operating cycle will be as follows: 1/3/05 Purchases 15/3 Sales 4/5 Cash rec’d from customer 2/4 Cash pay to supplier 32 days

19. Factors influencing working capital levels There is no fixed level of working capital or a time period for the operating cycle. The level of working capital and the length of the cycle is dependent on the following: The nature of the business ♦Some businesses require high levels of working capital while others need little or none 1.Retailers require lower levels of working capital, as most sales are on cash basis 2.Manufacturers requires higher levels of working capital, as the process of manufacturing goods from raw materials to finished goods take several weeks or months 3.Capital intensive industries may take larger amount of working capital

20. Factors influencing working capital levels Seasonality of the business Seasons sensitive business like air- conditioner manufacturers should experience an increased demand during summer time. The cash cycle will usually shorter for the business during the spring and summer time as compare the autumn and winter

21. Factors influencing working capital levels The creditworthiness of the business ♦This is measured in terms of the willingness of suppliers to give credit to the business. The credit period granted will depend on the length of time the business has been in existence, the track record of the business in paying its debts and the terms of trade expected in the industry. The level of credit granted will influence the level of working capital required to keep a business ticking over on a day-to-day basis. Example : Levis versus Giordano

22. Working capital management Business can improve its liquidity through the management of current assets as well as current liabilities. Current Assets management Managing stock ♦Stocks may be held in different forms: ♦Raw materials ♦Work in progress ♦Finished goods

23. Managing Stock The level of stocks held will be determined by a number of factors connected to the business and its industry: ♦The current and future availability of stocks. ♦The forecast of future demands for stocks. ♦The current purchase price, anticipated price changes, discounts and credit terms. ♦The costs of holding stocks in terms of storage, insurance, theft, deterioration, and obsolescence. ♦The rate of production and/or the time taken to purchase finished goods. ♦The pattern of sales over the year. ♦The reliability of stock control records and systems. ♦The availability of finance and the cost of borrowing to finance to the purchase of stock

24. Managing Debtors Debtors represent what is owed to the business in the short term. Trade debtors reflect sales by the business to customers on credit. The terms of credit granted to debtors are likely to depend on such factors as: ♦The tradition in the industry ♦The need to increase credit so as to increase sales and profits (business environment) ♦The customer’s reputation based on past payment records ♦The costs associated with debts including administration, bad debts and the opportunity cost of allowing the debt ♦The effectiveness of a businesses credit control system in terms of granting, regulating and controlling debts

25. Managing Creditors ♦Credit granted by suppliers on the purchase of goods is one important source of short term funds to most businesses. In effect, a business uses the money it owes to creditors to finance part or all of its current assets. ♦Many businesses rely on creditors to keep down the level of investment required by the business in working capital. ♦Using creditors is a relatively cheap way to finance current assets and the longer the period of time a business takes to pay its creditors the more of that money is available for other purposes. ♦ Consolidated purchases in a few suppliers, and negotiate for better credit terms (e.g. longer credit period, better cash discount)

26. Cash Management ♦Cash and money in the bank are part of the working capital of a business because they are needed to pay the bills. Cash, like stocks and debtors, should be kept at a minimum level. ♦ The aim is to have sufficient cash to meet all debts as they fall due, but this may not involve holding cash for this purpose. For example a business may be able to borrow money quickly, say by a bank overdraft, so reducing the need to hold cash. ♦Business should also consider the possibility that in holding large cash balances, they do not take advantage of more profitable opportunities that might occur.